Does Skill Really Matter in Stock Market Investing?

My young son once expressed concern when I told him I had money invested in the stock market. Perhaps he had seen stories about blindfolded monkeys throwing darts picking better stock portfolios than "expert" traders.

"Buying stocks is just like gambling," he said.

"No, it isn't," I explained.

I am not sure my son was convinced by my explanation, and I began to doubt it myself. What made me so confident that my process of choosing stock market investments was better than random chance?

How lucky stock picks can beat the market

People tend to overrate their investment skills as their portfolio grows. Over the years, the stock market tends to go up and the value of anyone's portfolio — even a portfolio picked by a monkey — would likely go up. But the measure of a successful investor isn't merely getting a positive return on investment. Real success is beating the market by getting a return that is better than the market average. This is where the skill comes in … or does it?

Let's consider randomly selected stock portfolios drawn from the broader stock market. Most such randomly selected portfolios will perform near the overall rate of return for the market. Some of the stocks may perform better than average and some worse, but the ups and downs across the portfolio tends to work out to about average. But by pure luck, some portfolios will end up with more winners than losers and beat the market average. Sometimes these randomly selected portfolios do a lot better than the market average.

For some specific examples, let's simulate portfolios randomly drawn from a market with 10.5 percent return and a standard deviation of 20 percent after 20 years. Under these conditions, the average return portfolio value based on the broader market is $7,366. Here were my "returns" from eight randomly selected portfolios after 20 years:

$4,330

$34,603

$19,572

$9,971

$10,925

$1,482

$8,482

$3,460

You can see that five of our eight randomly selected portfolio beat the expected value of $7,366 from average market returns over 20 years. One portfolio (#2) beat the market significantly, achieving an annualized return of 19.4 percent and growing 4.5 times that of an average portfolio. This portfolio was selected by pure chance, but the performance looks like something that would take a financial genius to achieve. If you were lucky enough to put this portfolio together, people would probably be lining up to ask for your investment secrets to learn how you beat the market. And since you were so successful, you might believe you had actually figured it out!

Our simulation results show that by pure luck, an investor could end up with a portfolio that greatly beats the market. A dart-throwing monkey could pick a great set of stock picks by chance. Random picks can result in underperforming portfolios too, but people tend to notice the big winners.

We have seen how you can end up with a high performing stock portfolio by pure chance. Does this mean that successful investors are just lucky?

The argument for investing skill

As we have seen, it is possible to get lucky and beat the market. But some investors seem to beat the market consistently. It's one thing to get lucky once in awhile, but is someone like Warren Buffett just really lucky, or is there more to it than that?

From reports over the years, we can see that Berkshire Hathaway beat the market 39 out of 49 years, earning more than the market average rate of return. A 2015 paper by James Skeffington uses some simplifying assumptions to analyze the probability that such a run of success would occur by chance. In a simulation with randomly drawn portfolios of 500 companies to represent the S&P 500, Warren Buffett turns out to be luckier than the luckiest of the simulated portfolios by a factor of about 100x.

While this analysis does not conclusively prove that Warren Buffett has exceptional skill as an investor, it does indicate that luck alone is not likely to be the secret of Mr. Buffett's success as an investor.

Should you throw darts to pick stocks?

The conclusion that skill — not just blind luck — likely played a big role in Warren Buffett's investment success means you could potentially study up and make informed investments or find a fund manager that can consistently beat the market through skill. If you want a piece of Warren Buffett's action, you could buy Berkshire Hathaway at a premium or a similar fund at a discount. (See also: How to Buy Berkshire Hathaway and Other Blue Chip Stock for 17% Off)

But in general, past performance does not predict future performance. If you see a fund that is advertising good recent performance, it does not mean the fund will stay hot. It is impossible to know if a fund manager is good or lucky, and investment strategies that work now may not keep working forever.

You could follow Warren Buffett's advice and go with index funds with low expense ratios that take away some of the risks, expenses, and inefficiencies of actively managed funds. As Warren Buffett's famous $500,000 bet showed, a low expense index fund can beat an actively managed fund. This investment strategy allows you to be successful without luck or skill. (See also: Why Warren Buffett Says You Should Invest in Index Funds)

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